In yesterday’s post, I wrote a little bit about what I’ve learned while researching an options strategy of trading long puts against high volatility equities. Today, I’m providing a concrete example of the strategy and my thought processes along the way.

The underlying for this example is AIG. I’ve continued to look for them as the underlying because this strategy is predicated on using an underlying with high volatility and the 30-day historic volatility for AIG has been above 90% since I started thinking about this strategy. About Tuesday of last week, I did an analysis of where AIG’s price was, what Nov09 puts were trading for, and decided to set a limit buy order for IKG WR at $4.30 as my entry point into the strategy. Let’s discuss a few of those phrases.

First, why Nov09 puts? Mostly because I had little confidence AIG would have the price swings I was aiming for prior to October expiration which was last Friday. But also because I didn’t want to add the additional risk of having to overcome the effects of rapidly decaying time premium. Much simpler to give myself a longer time period as a safety valve should I need to own the puts for longer than I was hoping.

Second, how did I arrive at a $4.30 limit order? This came about by doing calculations using the “greeks” delta and gamma. As a refresher, delta is the rate of change in an option’s price as a function of the underlying’s price change. And gamma is the rate of change in an option’s delta as a function of the underlying’s price change. To put these to use, I started by picking an underlying price that I thought would represent an achievable local high due to volatility. Which meant picking a probability level, I used 75%, a time period, I used 2 days, and then figuring out the price as a function of historic volatility. My equations told me to aim for a price of about $45.50. Now the greeks come into play. Using the difference between the current price and that price, I could figure out how much a given put option’s price would likely change as a result of changes in the underlying’s price.

This calculation generated a table where one column is the underlying’s price, another is the probability of hitting that price given the historic volatility of the underlying, and the others are the prices of various puts that I was considering. Now I simply scanned the table looking for a put who’s entry price fit within my capital requirements and where profit was maximized given a decent probability of hitting a low in the underlying. Because the delta and gamma will vary for each possible put, they have different responses to the same changes in the underlying’s price, and thus differences in how much profit can be earned given an equal drop in the underlying’s share price. Think of this as where you’re balancing risk vs. reward vs. capital requirements.

In the end, I decided to use the Nov09 $44 put on AIG. My calculations told me I had a 75% chance of entering if I set a BTO limit order at $4.30, and a roughly similar chance of exiting if I aimed for about $100 in profit before taking commissions into account. This meant using capital of little more than $430 on entry, and using a limit order to sell if the puts hit $5.30. Here’s the overall summary of the trades as actually completed. As usual, I’m including all commissions and fees and thus my numbers go out to fractions of a cent when shown as prices per share.

As I’ve recently posted, I’ve expanded my trading strategies to include using long puts on range-bound equities exhibiting high volatility. Even though I’ve only completed two round-trip executions of this strategy, both using AIG, I’ve already come up with a few notes that I want to record for the future.

Climbing the ladder to success

The basics of the strategy are to buy puts when the underlying stock peaks, and then hold them while waiting for the underlying to drop, at which point a STC (sell to close) for the puts is done. Because a put gives the holder the right to sell the underlying at the strike price, the price of the put options increase as the price of the underlying drops. To be more explicit, if you have the right to sell stock at $50 at a time of your choosing during the next two weeks, but you could buy it today for only $40, that right is worth at least $10. Back to the puts themselves, you can think about this strategy as an implementation of the old adage “buy low; sell high” where the lows and highs we’re aiming for are local maxima, over a day or two, in the price of the puts.

There are a number of risks to this strategy. Probably the largest is that the underlying stock makes an extended move in the wrong direction, in this case that would mean the underlying’s price rises. This can push the puts so far out of the money that the daily fluctuations (due to the high volatility we’re banking on) won’t be enough to move things back to a profit. If this happens, you’ve either got to try and wait for the price to plummet again, or settle for taking some losses. While your losses are limited to at most the price you paid for the puts, it’s not likely you want to lose 100% of that. Instead, a better option is to enter a triggered order to sell your put options at a price that is near your tolerable loss limits. You can’t simply use a limit order because a sell limit order will fill anytime the price is above the limit you set, and the price of our put should be well above that price right now. A trigger order solves this by allowing you to specify the price at which your order will be placed, in this case you might want something like “if the price on my puts drops by $1.00, place a market sell order”. In that example, we’re willing to lose about $100.00 per put. Remember each put is 100 shares.

Another risk to this strategy is that the volatility of the underlying stock drops. This will have a negative effect on the pricing of the puts because the volatility is directly related to the time premium of the options. If the time premium goes down, so does the overall price of the option. It should be obvious why this is bad. What would make the volatility go down though? This would happen if the underlying suddenly stops its wide price fluctuations and settles down to trading within a small range. Probably the best way to guard against this situation is to use the same type of trigger order as mentioned above, only the driver behind the price drop is different. It’s still a guard to limit losses.

The last risk worth mentioning is simply that of holding onto the puts for too long. This is because, not only does it give fate more chance to do either of the two above mentioned things, but it also allows for decay in the time premium of the options. And the time premium, on a highly volatile underlying like we’ve based this strategy on, is a large component of the price paid to originally buy the puts. It will be quite hard to sell at a higher price if this all trickles away to nothing. My current thoughts on protecting against this are to start the execution of the strategy by having a target time period over which you’re willing to wait for volatility to do its thing and push the prices of your puts to the high you’re aiming for. As soon as that period expires, drop your target profit level and try again. The amount you’d drop your target profit by depends on how the underlying has moved while you’ve been waiting; how much, if any, the volatility of the underlying has changed; and how fast the time premium is changing. In my experiences so far, I’ve been aiming for profits that I thought were likely to hit within 2 days. But after those two days, I’d generally be willing to drop my target by 50% to 75%, but keep in mind there is little math to back up those numbers on my part. At least so far.

As you can probably tell by now, I usually establish a target profit before entering into the strategy. And then as soon as the entry is executed, I enter a limit sell order to automatically take that profit should it occur. Because I also want to enter that contingent loss limiting order, the profit taking order has to be a conditional order as well. But while the loss contingency triggers a market order, the profit triggers a limit order. I’m not sure this is strictly necessary, and it once meant the order got triggered but not filled. However, it’s easy enough to cancel and reset the contingency trigger.

Tomorrow I’ll post a concrete example of this strategy by writing up the summary of my second long put adventure in AIG.

October’s option expiration was this past weekend, and like last month, we had three covered calls in play that ended with this month’s expiration. Two of those got assigned (AIG and Intel) and one simply expired (Eastman Kodak), thus we did reasonably well in matching our maximum profit. But before I provide that summary, let me digress with a little summary of what we’ve learned so far in trading covered calls.

Colors of October

As a reminder, we’re doing covered call trades in our GI income portfolio for two purposes: first, to earn current income and second, to learn more about options trading and strategies. We believe that, in the long term, options trading could be a very good way to bump up our income while traveling, and could do so in a mostly passive activity sort of way. Which, after all, is what our Geographic Independence goal is all about.

We’ve been mostly focusing on covered call trading because, for one thing, our broker allows us to do it. Even though our GI portfolio isn’t a tax-advantaged, retirement account, most brokers still restrict the types of strategies you may use based on factors such as liquid net worth, years of experience in trading options, and the type of margin you have. In our case, TradeKing rates us at “options level 2” which allows little more than covered calls. Secondly, we’d been using that strategy because there is a lot of literature available (in books and on the ‘Net) recommending it as a good way to start trading options. I’ll admit, at first glance the risks aren’t too great from simply buying and holding the stock. However, as I’ve found out, you’re trading large potential upside for immediate income, which could also be thought about as insurance from minor losses. The net result is that covered calls aren’t the best strategy to use in a rapidly rising market.

Unfortunately, that is almost exactly what we’ve had since March. Which means that our GI portfolio hasn’t grown as much as it might have otherwise. On the other hand, we’ve learned quite a bit about options in the progress, so I’m thinking of the money we left on the table as if it were tuition. All in all, a pretty fair trade in my opinion.

So, how about that summary of our options expiring this month? As usual, I’m including the commissions we’ve paid and thus some numbers go out to fractions of a cent.

Note that, with the AIG trade, we aimed for decent profits while trying to protect ourselves as much as possible from a downward trend in the underlying. We were able to find a situation (mostly due to high IV) that earned a 100% APY but had a cost basis that would have provided some profit all the way down to $35.01 — a drop of 19.81% in the underlying. AIG never went below our strike during our holding period, though it did get close, so I’d say we got lucky. I was watching for an exit sign of a net credit quote near $33, but I never saw that come up.

This EK trade was found using TradeKing’s option strategy scanner software with a focus on staying within my capital and looking for a decent risk vs reward situation. While my position ended with unrealized losses (EK closed at $4.27 on Friday), I may end up selling new Nov calls on it. Though, I may also cut my loses and sell out the position for a loss. I don’t have strong feelings about EK, so it primarily matters on what is happening in the market once it opens. Friday’s closing bid/ask midpoint ($0.175) for the Nov09 $5 call certainly isn’t all that attractive.

The INTC trade came about primarily because I’m still expecting a correction in the market, but felt, from my own experience in working in tech, that things there were going well enough to balance my fears of the correction. I was also underweight in tech exposure in all of my portfolios, so this felt like a good time to force myself to pay attention to the industry a bit more.

So, if we ignore unrealized losses, this month we brought in $370.89 on invested capital of $7,800.85. That’s a return of 4.75%, or an annualized yield of 116.11%. If we do end up having to sell out of EK for a loss, using Friday’s closing bid of $4.27, things would come down to $173.94 in income or 2.23%. An annualized yield of 44.18%. Oh, and this doesn’t include my experiments with short-term, long, put trades on AIG that I started this month. I’ll write about that a bit more soon.

So I’ve been watching AIG pretty closely given my current in-play covered call trade, and I’ve noticed that the daily highs and lows can be pretty large swings. I’ve also noticed that, over the last few days, it seems to be swinging through the same range of prices over and over again. Having just read about trading puts, I decided to dip my toe in the water by doing a long put with AIG.

Making income from volatility

The strategy I wanted to use for my “toe dip” was to place a One-Triggers-Other (OTO) trade on a single put option. The single put so as to minimize the amount of money lost if something goes wrong. Yes, I know that maximizes the losses from commissions but I’m in a learning mode here. And the OTO so that I could use limit orders and not have to watch things constantly. Also, this enforces the “take a good deal and not be greedy” mantra — lowers my risk of missing a good profit while waiting for a great profit.

Describing the whole thing another way, basically I would set a limit order to purchase a put option (“go long a put”), and when that got executed (the trigger), my broker would immediately turn around and automatically place another limit order to sell that same put option, but for a profit. The outstanding question was how to decide what prices to use for the limits?

In my recent tracking of AIG, I had noticed that TradeKing was quoting 30-day historic volatility for AIG at “99”. (As of right now, it’s down to 95) It’s my understanding that the units of that quote are percent, so I think (please correct me if I’m wrong) that’s basically like saying AIG could double, or go bankrupt in 30 days. That’s pretty freaking high volatility! I then looked at more recent data, a chart of the last 5 trading days, and noticed that AIG seemed to be leveling off its recent steady climb and was range bound between the high $37s and high $46s, but it was mostly fluctuating mostly between $43 and $45. I decided to try and buy an OTM put at a high above $45 and then sell anytime the option price rose by $0.50. With OTM strikes having deltas around the low -0.4’s and high -0.3’s, when AIG was near $45, a $0.50 gain should mean a price drop in the underlying of about $2.50 to $3.00.

How likely was this to occur? Well, I tried working out the math for that based on TradeKing’s 30-day historic volatility number, but never got comfortable I was doing it right. Pretty much my math was telling me that there was about a 49.98% chance AIG would drop the requisite amount within a day. And that there was a similar chance the option price would be what I was targeting for my profit after 10 days (roughly by October expiration.)

In the end, I skipped the rigourous math, punting on my “long put” spreadsheet for now, and did a gut feeling based on the 5 day charts. I felt pretty comfortable that the necessary volatility was there simply by looking at the charts. So the next step was to wait for a bit of an upward spike in AIG trading prices by placing a limit BTO order for the option at $2.50. Recent trades had a time premium of $1.92, so this meant waiting for AIG to get above $45.58 ($2.50 – $1.92 + $45 (my target option’s strike)). AIG was trading right around $45 when I placed my OTO order. Note that I chose a just out-of-the-money strike in order to minimize the delta (delta is negative for put options). The larger the absolute value of the delta, the more the option price moves when the underlying moves, thus minimizing the amount AIG would have to change for my profit target. In the end, I decided to enter the following OTO order:

And here’s the summary of the actual round-trip, executed trades. You can see it took less than a day for my round-trip to complete. As usual, I’m including my actual commissions in the numbers so that explains the fractions of a cent.

It should be noted that, while I have a pretty good return percentage here, the risk is 100% loss (the put option expires worthless). Realistically, I never planned to hold the put for more than two days, I would have simply sold and taken my loss at that point. I find it very improbable that the put would become worthless during that kind of time period. It’s gamma (or rate of decay of the time premium) was only 0.029, so it shouldn’t all leak away during two days. [EDIT: What I was thinking of here was theta. Gamma is actually the rate of change in delta as the underlying’s price moves. But now I can’t find the historic value of theta at the time of the original post, so I can’t confirm if I just had the wrong name or also the wrong value.]

I’m now wondering if it’s possible to use a One-Cancels-Other order to set both a loss limit order and a profit limit order. For the trade above, I manually watched the prices on the option in order to gauge if I had to cancel my profit order and replace it with a loss limiting order. Luckily, I never saw it go more than a few cents below what I had paid for it.

One last note, there was a sharp price drop in AIG today, which is why I got my $3.oo sell limit executed. But it continued past my limit, and when I got the notice of execution for my limit, the IKG VS option was trading with a $3.26 mid-point between bid/ask. That would have been an additional $25 in income, but there’s no way to gauge this unless you’re watching things real-time (which I can’t do.) Anyone have any suggestions on a way to place broker orders that could automatically catch this gain? Perhaps a conditional stop loss order of some sort?

As you might gather from reading this blog, I’ve been doing lots of research into options and options trading strategies. I’ve just recently decided that it was time to position myself for the next step: putting what I’ve learned into use on more of my family’s investments. A large chunk of our portfolio is in Fidelity IRAs, so for me, this meant completing the paperwork to move over to one of them to a ThinkOrSwim IRA.

Thinking about swimming

In my earlier, uneducated, days of IRA investing, I listened to the “financial advisors” brought in by my employers as part of their 401(k) programs and bought their recommend mutual funds, which unfortunately for me had high annual fees. (My IRA includes a couple of 401K rollovers.) Eventually, I realized the impact of these fees and set out to transition to lower fee funds (and NTF too!) Even later, I realized I had a large enough portfolio that I could get reasonable diversity in US large caps by investing directly on my own, and thus cut out the fees all together. Whoosh, a large part of my account sold out of mutuals and moved to individual equities. Through all of this, I’ve happily been using Fidelity as my IRA broker.

But now that I am thinking of applying options strategies in my IRA, I find that Fidelity has a few barriers set up for me. First is that Fidelity limits the types of option strategies you can apply in an IRA, and they make it really hard to find this information on their website. For example, as part of my research for this post, I can’t find a single way to see the options levels for IRAs until I eventually start the 9-page application process. I’m on page 6 before I even *see* the account options levels. Turns out that IRAs only have access to two levels. Either “Covered call writing of equities” or “Purchase of Calls/Puts/Straddles/Combinations (equity and index)”. I’m already approved for the second and have found that Fidelity won’t even let me preview orders for some strategies (Iron Condor) I was thinking of trying. Second, as I’ve blogged about earlier in the year, their commissions on options are pretty high. The ‘Silver’ commission rate (for those with accounts totaling between $1M and $50K) is $10.95 plus $0.75/contract. Anyone just starting out is looking at “Bronze” commissions of $19.95 plus $0.75/contract!

So why choose ThinkOrSwim? Could it be that they send US customers who fund their account a free “highly fashionable TOS monkey as a token of our appreciation“? While apparently the stuffed monkey is highly coveted, the real draw for me is this line from their IRA account description page: “you can trade any complex option strategy you like as long as the resulting position has defined risk.” From reading other blog postings, this means you can indeed do Iron Condors, or use long positions on LEAPs as a way to set a defined risk on short near month trades, etc.

And on the commissions front, they have an interesting setup where you can choose between one of their own rate schedules or pick a commission schedule from a major third-party broker. I can’t comment too much on that last choice yet (because I don’t have an active TOS account), but the standard TOS schedule for which I qualify sounds pretty good to me: the commission is either the lesser of $2.95/contract -OR- $9.95 plus $1.50/contract (only one $9.95 charge per unlimited spread legs.) If I’m understanding that correctly, a single iron condor would thus incur commissions of the lessor between $11.80 (4 x $2.95) or $15.95 ($9.95 + 4 x $1.50). i.e. $11.80. As a point of comparison, at Fidelity this would be $13.95 (and at TradeKing it would be about $22, ouch!) Looking at the more typical trades that I’ve done, things look even better. Selling a single call would be a $2.95 commission vs. Fidelity’s $11.70 (TradeKing’s is $5.60).

There are also many other things I’m looking forward to at ThinkOrSwim. Such as $0 commissions when BTC short individual or single leg options for $0.05 or less — this will help minimize risk by closing out calls early and thus avoiding expiration day volatility. And then there’s the 3 complimentary mutual fund trades per month, including the Vanguard family of funds (though I’m not sure yet if Vanguard charges their own load fees in this setup.) And, like many brokers, ThinkOrSwim also offers rebates on account transfer fees. Currently, they will rebate up to $100 for a transfer of at least $3,500. And then there’s their highly rated software trading platform (which I haven’t done much to explore yet.) And, it almost goes without saying, TOS has no annual IRA fees. Oh, and then there’s that free monkey thing.

Pages

Disclaimers

We are NOT certified financial planners, nor any other sort of licensed investment advisor, so please consult with an investment professional before you invest your money. This site is for educational and entertainment use only. The opinions presented on this site in no way constitute financial, investment, tax or any related forms of advice. We are not liable for any losses suffered by any party because of recommendations published on this blog. Past performance is not a guarantee of future performance. And unless your investments are insured via the FDIC, NCUA, or GEICO, they may decline in value.